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Duty to Monitor
The issue of liability for failure to monitor raised by the Francis case takes on significant in large enterprises where board's policy is impliemented by officers and employees. Modern View Directors should implement procedures and programs to assist in their monitoring role. Over the years, courts have recognized the importance of the role directors play and their duty to keep themselves informed. Since the Graham case there has also been expanded criminal liability to corporations under federal statutes, federal sentencing guidelines have provided for lesser sentences to corporations that have implemented compliance programs. Thus, directors do have some responsibility to implement appropriate reporting or monitoring systems. In the Delaware Chancery Court decision In Re Caremark International, Inc. Derivative Litigation recognized the trend and viewed the Graham case more narrowly. In Caremark, the corporation had paid $250 million in fines and damages because the employees had violated the law applicable to the health care industry. A derivative suit was brought against the directors for breach of their duty of care by a failure to monitor the employees. The case involves an approval of the settlement of the suit by the court. In reviewing the fairness of the settlement, the court looked to the vialibility of the claims. Even though huge civil and criminal penalties were imposed on the corporation, the court found no breach of the duty of care. There was no evidence of lack of good faith in monitoring or knowing violation of the law. But contrary to the broad reading of Graham, the court found that directors have a responsibility to assure that an adequate system exists for receiving corporation information and reporting, including compliance with relevant statutes and reulgations. Thus, even if there is no reason to suspect a lack of complicance, some monitoring system must be in place in order to satisfy the obligation that directors need to be informed for both legal complicance and decision making. According to the court, directors would be liable if there is a sustained or systematic failure to exercise overight sufficient to indicate a lack of good faith (for example, if there was ignorance of liability and an utter failure to attempt to assure a reasonable information and reporting system exists). But the court indicated that this test of liability is high because a demanding test of liability is necessary to attract outside directors while still providing a stimulus to good faith performance. Further, the level of detail appropriate for the system is itself a question if business judgment. Again, the court did not clarify whether good faith was a distinct fiduciary duty. In Stone v. Ritter, the Delaware Supreme Court was faced with a Caremark type claim of a failure to monitor and the issue of good faith. The caes concerend a bank which failed to file reports aimed at possible money laundering and was subejct to $40 million in fines and $10 million in civil penalties. No fines or penalties were imposed on the directors. The regulators had concluded that the compliance program in place was "materially deficient." As part of the bank's deferred prosecution agreement with the government, they hired a consultant (KPMG) to review the bank's compliance program and to make recommendations for changes. Because the litigation was a derivative suit (i.e., shareholder are bringing action on behalf of their corporation which alleged a breach of fiducairy duty that essentially harms the corporation), the plaintiff shareholders are required to make demand on the board of directors prior to filing the cause of action. Plaintiffs tried to avoid the demand requirement which could end their litigation by claiming that such a demand on direcotrs who are accused of the fiduciary duty breach should be excused as futile. The plaintiffs were required to allege with particularlity that the directors were incapable of handling the litigation. There was also a section 102(b)(7) exculpation of duty of care damages in the bank's certifcate of incorporation, so plaintiffs seeking damages needed to allege conduct that woudl not be covered by duty care such as failure to act in good faith in order to excuse the demand. Given the allegations were a failrue to exercsie oversight, the court adopted Caremark's view of Graham adn that oversight responsibility was an issue of good faith. The court also reiterated the Disney examples of the failure to act in good faith as: 1. an intentional act in not advancing the corporation's beset interest; 2. an intent to ivoate positvie law; or 3. intentionally failing to act in the fact of a duty to act i.e., a conscious disregard of their duty. All of these examples requrie some form of intent or scienter. Both Caremark and Stone dealt with the third example which implciated oversight liability. This can invovle either an utter failure to implement a reporting system or a system was created but the directors consciously failed to monitor or oversee it thus limiting their baility to be informed. Either situation requires the directors knowing of the failure to act when there was duty to act, i.e., a conscious disregard. In Stone the bank was accued of the second failure because there was system in place. But there was no allegation of "red flags" raising awareness that the system was inadequate and would result in illegal activity because the baord id nothing. While the illegal activity was harmful to the bank and the result of inadequate internal controsl, the fact that there were substantial fines does not alone establish bad faith. Directors cannot be held liable just becaues employees have done somethign wrong. There needs to be a sustained or systematic failure to exercise oversight such as an utter failreu to attempt to assure a reasonable informatino and report system exists. The court quoted Caremark's concern that this test need to be high in order to attract the kidn of directors needed to monitor and protect the corporation. Given the KPMG report of a system in place ex ante was reasonable, the failures and resultant large fines do nto equte with bad faith and the court shoudl not second guess ex post. Stone also indcated taht the failure to act in good faith does not isefl impose liability but does so because good faith is "a subsidiary element, i.e., a condition of the fundamental duty of loyalty." Thus, good faith is not an independent fiduciary duty but the lack of good faith means that he directors are not acting in the best interest of the company and they are breaching their duty of loyalty. It is unclear how significant Stoen adn its notion of good faith will be. Proving good faith will be difficult sicne ti must be conduct motivated by subjective bad itent and with an actual intent to harm the corporation or an intentional dereliction of duty and a conscious disregard for one's responsibilities. The enactment of the Sarbances-Oxley Act of 2002 in the wake of corporate scandals has treid to enhance monitoring by directors and a firm's internation controls to avoid illegal activities. The increased federal reulgations aimed at publicliy traded corpoation plus the fears of criminal prosecution and liabiltiy will porably be the main impetus for driector to minotir. The lack of good faith also has a role to play in corporations with controllling shareholders. In a post Sonte case, the Delaware Chancery Court, in ATR-Kimg Eng Fin. Corp. v. Araneta, found liability for directors of a clseoly held cororpation who allowed the controlling shareholder to basically self deal by transferrign assets unfairly and impoverishing the company. While the cotnrolling shareholder breached his duty of loyalty, the other directors who were not self dealing but who did ntohign were found to be liable. The corut described them as "stooges with these directors havign no regard for their obligations as directors. They consciously acted as a tool for the cfontrolling sharehodler as opposed to trying to make decisions for the best interest of the corporation. According to the court, directors in order to act loyally (i.e., in good faith) must make a genuine good faith effort to do their job and assure an adequate information and reporting system exists. Here there were no systems nor were they any board meetigns. The directors did nothing to make themselves aware of the problems or try to stop it. Even though they themselves did not self deal they wre found to consciously breach their fiducairy duty and were held jointly liable. Older View In the Delaware case of Graham v. Allis-Chalmer Mfg. Co., the directors failed to prevent antitrust violation by employees. Plaintiffs claimed that the directors should have known about the liability and that they had a duty to implement complicance with the law, especially since the corporation had agreed to a consent order 20 years earlier to not violate the antitrust laws. The Delaware Supreme Court found no duty of care liability and in broad language indicated that unless they had reasons to suspect the existence of a violation, directors had no obligation to install a system of monitoring or reporting (that is, a duty of inquiry). They are entiteld to rely on the honesty and integrity of the employees. This was especially true given the large size of the corporation.